There was plenty of blame to go around in the aftermath of the financial crisis, as evidenced by a series of well-publicized congressional hearings that examined the wrongdoings of investment bankers, credit rating agency executives, and Federal Reserve officials, among other culprits. But what about the Financial Industry Regulatory Authority (FINRA) and other self-regulatory organizations (SROs) that were supposed to be the front-line regulators and enforcers of the financial services industry?
POGO believes that the failure of these self-regulators played a big role in the government’s inability to prevent the economic meltdown. That’s why we sent a letter to Congress today calling for increased oversight of SROs, and questioning whether an organization like FINRA can ever be trusted to protect the investing public given its incestuous ties to the industry it is tasked with regulating.
History of SROs and FINRA
Most Americans probably haven’t heard of FINRA or SROs, but the concept of self-regulation is deeply embedded in our financial regulatory framework. Congress first recognized SROs in legislation passed in the wake of the stock market crash of 1929, when it became clear that stock exchanges and over-the-counter (OTC) securities dealers were failing to regulate widespread market manipulation. A 2004 Securities and Exchange Commission (SEC) concept release explained the reasoning behind Congress’s decision to formally recognize self-regulators as overseers of the securities industry:
In enacting these provisions, Congress concluded that self-regulation of both the exchange markets and the OTC market was a mutually beneficial balance between government and securities industry interests. Through establishment of self-regulation, the securities industry was supervised by an organization familiar with the nuances of securities industry operations. In addition, industry participants preferred the less invasive regulation by their peers to direct government regulation and the government benefited by being able to leverage its resources through its oversight of self-regulatory organizations.
Fast forward to 2007, when the SEC approved the creation of FINRA by combining two other self-regulatory entities: the National Association of Securities Dealers (NASD) and the regulation, enforcement, and arbitration functions of the New York Stock Exchange (NYSE). In its proposed rule change, NASD argued that “consolidation will...serve to enhance oversight of U.S. securities firms and help ensure investor protection,” and that the “investor ultimately would be better protected by a single, more efficient regulator.”
Today, FINRA continues to highlight its commitment to “putting investors first,” and over the past year, the organization has been promoting itself through advertisements in The Washington Post, commercials on CNN, and “public interest” spots on National Public Radio. In fact, FINRA thinks it should be given the authority to regulate not just securities brokers, but investment advisers as well. In an attempt to justify this expanded authority, FINRA Chairman and CEO Richard Ketchum told Congress that FINRA has a “strong track record in our examination and enforcement oversight.”
In our letter today, we argue that FINRA’s track record actually tells a very different story, one that is typical of financial self-regulators that have a cozy relationship with the industry they are supposed to be regulating. POGO believes that SROs, despite the power vested in them by the federal government, have effectively been asleep at the wheel during all of the major securities scandals dating back to the 1980s.
Regulatory and Enforcement Failures
FINRA’s recent failures are detailed in Amerivet Securities, Incorporated v. FINRA, a case that is currently pending before the D.C. Superior Court in which Amerivet, a California-based broker-dealer, is seeking to access some of FINRA’s books and records. As Amerivet’s complaint points out, FINRA failed to regulate many of the larger firms that were at the heart of the financial crisis, including Bear Stearns, Lehman Brothers, and Merrill Lynch. Even an internal review conducted by FINRA itself found that the organization missed several key opportunities to investigate the securities fraud by R. Allen Stanford. And while FINRA officials have denied any wrongdoing in the failure to detect Bernard Madoff’s Ponzi scheme, securities law scholar John Coffee testified before Congress that “Madoff’s brokerage business was by definition within...FINRA’s jurisdiction.” A recent investigation by The Wall Street Journal confirmed that FINRA and its predecessor NASD, under the leadership of current SEC Chairman Mary Schapiro, had a decidedly light touch when it came to regulation and enforcement, with significant declines in disciplinary fines assessed, individuals barred, and firms expelled during her time at the organization.
It appears that FINRA also failed to warn the investing public about the risks associated with investing in auction rate securities (ARS). Many investors thought these were safe, cash-like investments that paid a higher yield than money market mutual funds or certificates of deposit. But in February 2008, the auctions for these securities failed, leaving investors stuck with tens of billions of dollars that are now frozen in the ARS market. Of course, FINRA neglected to inform investors when it liquidated its own $647 million ARS investment in 2007. In fact, NASD (FINRA's predecessor) knew well before then that ARS shouldn’t be treated like cash or cash equivalents, explaining in its 2003, 2004, and 2005 annual reports that it was classifying its own auction rate securities as available-for-sale investments. We think Congress should at least investigate the circumstances surrounding NASD’s liquidation of its ARS investment before deciding to grant FINRA any additional authority to “protect” investors.
Outrageous Compensation Packages
Despite these numerous regulatory and enforcement failures, FINRA’s board has approved outrageous compensation packages for the organization’s senior executives. Tax documents show that in 2008—a year in which FINRA also lost $568 million in its investment portfolio—the organization’s 20 senior executives received nearly $30 million in salaries and bonuses. Mary Schapiro alone received over $3 million, in addition to a lump-sum departing payment that was worth $7.2 million. FINRA’s decision to reward its senior leadership with seven-figure salaries and bonuses—at a time when many of its larger member firms were getting away with securities violations that brought our financial markets to the brink of collapse—ought to raise serious concerns about granting the organization any additional regulatory authority.
Conflicts of Interest
Of course, we shouldn’t be surprised to learn that FINRA is a weak and ineffective regulator, given the incestuous relationship that often exists between SROs and the financial services industry. Throughout the years, NASD/FINRA’s senior leadership positions, board of governors, and committees have all been filled with current and former executives and board members from the securities industry, including some of the firms whose reckless behavior fueled the financial meltdown and drew investors into Ponzi schemes. For instance, the Amerivet lawsuit claims that “Bernard Madoff joined NASD’s Board of Governors in January 1984 and served as Vice Chairman while his Ponzi scheme was well underway.” There were also close connections between FINRA and Allen Stanford’s firm, which was later found to be running a Ponzi scheme.
Even after the financial crisis exposed the problem of regulators captured by industry, FINRA remains in bed with some of the very same firms it’s supposed to be regulating: for instance, Richard Ketchum served as former General Counsel for the Corporate and Investment Bank at Citigroup, Inc.; Robert Errico, FINRA’s Executive Vice President for Member Regulation, is a former Senior Vice President for Capitals Market Oversight at Charles Schwab & Co., and a former General Counsel for Schwab Capital Markets L.P.; and Susan Merrill, FINRA’s Executive Vice President and Chief of Enforcement, is a former partner at Davis Polk & Wardwell, which represents some of the largest financial institutions in the world. And on FINRA’s Board of Governors, many of the members who are supposed to represent the public’s interest have close ties to the securities industry. Given that SROs such as FINRA are supposed to be the front-line overseers for many financial products, POGO believes that the cozy relationships built into this system create a serious conflict of interest.
A Good Deal for Taxpayers?
Proponents of the self-regulatory model often claim it’s a good deal for taxpayers since SROs like FINRA are funded by their members. In explaining why FINRA should have more supervisory authority, Ketchum told Congress that “the increased manpower and enhanced investor protection would come at no cost to the taxpayer.” The problem is that FINRA’s member fees simply get passed on to investors in the form of transaction costs. And taxpayers still have to foot the bill for the SEC’s routine oversight of FINRA, which entails approving SRO rules, monitoring their activities, hearing internal appeals, and overseeing board activities.
Time to Remove the Fox from the Henhouse
POGO calls on Congress to thoroughly reexamine the government’s long-standing reliance on self-regulators to police the securities industry. Time and time again, FINRA and other SROs have made it abundantly clear that they are either unwilling or unable to protect the investing public from securities fraud and other market abuses. Our fragile economy is simply too important to be left in the hands of a weak regulator that is in bed with the very industry that brought our financial markets to the brink of collapse.
-- Michael Smallberg
Further reading:
